Lending is Risky
Are You Keeping Your Ratios in Line?
Lending money is a risky business. Making loans to people with bad credit is perhaps the most risky financial endeavor, especially from a traditional banker’s perspective. They simply won’t do it, and affordable loans for working capital to those who loan money to people with bad credit is very scarce. Additionally it is expensive thanks to the billions of dollars of irresponsible and now “toxic” mortgage loans that were passed on to investors as “subprime” loans. So, where does that leave us—those who earn a living in automotive special finance? The answer lies in how we mitigate risk.
Automobile buyers who need specialized financing are everywhere, and it seems they’re multiplying. If your dealership is branded as a place for consumers to go if they have credit problems, you have no shortage of customers. What you have is a shortage of buyers with “buying power” and finance companies willing to give you enough money to make a profit. The real challenge is just being able to effectively sort through the chaos and find customers who actually have a down payment and/or a co-signer with halfway decent credit, so you can put together a profitable deal.
Working the desk at many of these stores, both large and small, reminds me of a military triage unit like MASH, where doctors sift through the incoming casualties and prioritize those most worthy of saving. Subprime buyers quickly get put into one of three categories. For the sake of argument, let’s call them the good, the bad, and the ugly. The good buyers are those with enough stability, capacity and credit that they can be placed with the larger secondary finance companies like CitiFinance, Capital One or AmeriCredit. The bad ones are those who are going to require a lot of work to put a deal together, but if you have inventory that you stole at the auction, with significant cash down and a little luck, you may be able to make a profitable sale. Then there’s the ugly, those recently-paroled credit criminals with FICO scores below a 500 who would rather walk than drive a Ford Taurus, but who look good talking on their iPhone in their Dolce & Gabbana glasses and designer clothes.
Within the past two years, we have collectively lost approximately 40 percent of our ability as an industry to finance these subprime buyers. The main reason is not just the limited availability of capital but rather the shrinking profit margins for dealers as finance companies manage risk to protect their portfolios from the worst economic crisis any of us have ever experienced.
Loan-to-value (LTV) caps have gone from the 140-percent to150-percent range to the 100-percent to 110–percent range with payment-to-income (PTI) targets below 10 percent of verifiable gross monthly income. To further complicate matters, the vehicle wholesale market has been highly volatile and the finance companies’ preferred valuation guide books have been unable to keep up with the dramatic changes, taking money right off a dealer’s bottom line.
Take a look at this illustration of comparable deals in 2007 and 2009:
When you initially glance at the numbers, they seem far-fetched. However, when you’re actually desking deals today, the scenario is all too common. Two years ago, a sloppy dealership could generate decent profits in special finance while well-managed teams were benchmark performers with average gross profits above $3,500 per vehicle. However, you have to be an A-list player just to be in the game today.
In order to earn a profit, dealers have to be able to find and recondition sellable inventory that is still behind book. They must have three to five quality finance companies that cover the full spectrum of finance and have near-perfect sales processes in place that raise down payments and generate profitable sales. They also need a highly talented SF manager who knows how to quickly make an accurate credit decision, structure deals and direct the sales staff. There is absolutely no margin for error or sloppy operations today. Everything has to work in unison because when the up bus arrives, it’s game time.
We’ve all had enough bad news over the past couple of years and I certainly do not intend to sound pessimistic. By the same token, I’m not going to blow sunshine at you and tell you everything’s going to get better soon and we will be back to the plethora of generous subprime lending sources. The truth of the matter is that we probably won’t be going back to those days again. That being said, special finance is still alive and kicking for those dealers who recognize the opportunity and have the talent, resources and processes to capitalize on it.
The finance companies have adjusted their game plans to better manage the risk of financing vehicles for people with bad credit because they know that the consequences for poor decisions would be their demise. The meters they use to gauge risk are capacity, collateral and deal structure. Capacity is the applicant’s ability pay for the loan and is measured in terms of PTI and debt-to-income (DTI). Collateral and deal structure go hand-in-hand and are measured in terms of LTV. These risk factors are how the banks compete, and we dealers have to realize that the finance companies are not willing to take the same risks they were a couple of years ago.
We have to do the same as the finance companies—adjust our game plans and react accordingly. Fact: Special finance is not going away. We need to master financing options for people with subprime credit. Fact: We need finance companies. We need to value every aspect of the relationship we share with our bankers and build partnerships for success. Fact: We need to take care of the customers who arrive at the dealership wanting to purchase a vehicle because the ultimate risk for any business is turning away would-be buyers who will find alternatives.
The metric I use to measure this risk is the sales conversion ratio (the percentage of people who physically show up at the store and actually purchase a vehicle). Anytime this closing ratio gets below 20 percent, I get alarmed. And if the number drops below 10 percent, the team is headed back to the minors. Healthy closing ratios are above 30 percent, which is in line with benchmark performers who still manage to maintain an average gross profit of $3,000 or more per vehicle.
Look at it from another perspective. If nine out of 10 customers are leaving your store empty-handed, what do you think they are telling their family and friends about your dealership? You probably won’t like the answer to that question. If you ignore these warning signs of poor conversions, your team will lose faith in the business and quickly burn out on dealing with subprime customers. Before you know it, everything else about your special finance operation will start unraveling. However, if you focus the attention and efforts of your team on achieving and maintaining a closing ratio of 25 percent and balance that number with an average gross profit of $2,500 per vehicle sold, you won’t have any shortage of customer traffic or profits.